Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Friday, January 11, 2013

2012: A Retrospective…..And Fair Warning for Things to Come.

This being early January, most readers have spent the past
several weeks dreaming of which new Apple products were wrapped up under the
tree, gorging themselves on holiday food, and then guiltily planning an
exercise regimen to work off the season’s excesses. Also, they have likely been
inundated with numerous year-end financial market summations and forecasts for
2013. Rather than simply catalog what
factors have driven markets over the past year, this posting will attempt to
separate the fundamentals that should
impact markets vs. the sway being felt on account of policy initiatives (i.e.
market distortions) during this extraordinary period. Lastly, we shall
highlight a few potentialities of which investors should be aware during the
coming twelve months. True, this is a step short of market calls, but by not
getting into the business of forecasting, one can avoid eating copious amounts
of crow come next January. As stated, these are extraordinary…and thus
volatile…times.

Equities

What Happened.

The S&P 500 rose 13.4% in 2012…and has tacked on a few
more percentage points in the inaugural week of 2013. Mid-teens returns are
nothing to sneeze at. But as seen in the chart below, the ride was anything but
silky smooth. It may come as a surprise that in a year which included the
uncertainty of a U.S. presidential election, slowing emerging market growth,
lackluster earnings and in the final few months, absolute mayhem with regard to
the fiscal cliff, stocks managed to register such gains.

The chart also illustrates how much in lock-step equities
moved, with large-caps, small-caps and even emerging markets following similar
paths. One may see this as evidence that stocks were the beneficiary of the
(partially Fed-induced) binary risk-on / risk-off trade that has hovered over
the market since the outbreak of the financial crisis in 2008. But that would be overlooking a few true strengths
currently present in equities.

What Does it Mean?

Stocks can rise for myriad reasons. Two especially
compelling ones are cheap valuations and increased profitability. Both are
present at this time. When including Q4 2012 earnings estimates, the S&P
500’s trailing P/E ratio is 14.4. Based on full-year 2013 estimates, the
forward P/E is 12.7. Both are well below the long-term average. Despite having expanded 20% since late 2011
(from 11.95), valuations remain relatively attractive.

With regard to profitability, corporations are still
(miraculously) managing to squeeze margins in order to goose earnings despite
weak top-line growth. True Q3 2012 was a major dud, but estimates for the
recently completed quarter calls for earnings growth of 7% despite a sclerotic
3% rise slated for revenues. As a consequence, profit margins for many index
members are at their cyclical peak. So with regard to equities, it can be
argued, a solid 2012 largely reflects positive fundamental factors. That said,
I won’t put up much resistance to advocates of the position that part of the
13% gain in the S&P is due to yield-starved investors attempting to seek a
home for their money.

And Going Forward…..

What goes up must come down, and profit margins at this
level won’t last forever. That reality is one headwind pushing against stocks
as we enter the New Year. The inability of corporations to grow sales is
another. By some estimates, S&P 500 earnings will rise 13% in 2013, a
marked improvement over 2012’s paltry estimated rise of 3%. Such a gain would
almost certainly require a bump in revenues as more cost cutting is analogous to
job losses, which risks a downward spiral in a consumer-driven economy.

A serious hurdle to sales growth is the fact that most
Americans (not just the uber-rich) are about to get whacked with a tax
increase. This is a consequence of the payroll tax…..which is a very regressive
variety….returning to pre-crisis levels. In an economy dependent upon the
consumer for 70% of all activity, this is no small deal. Once the smokescreen
of income taxes for high earners lifts, most Americans will see a tangible
chunk of their paychecks missing. This means fewer trips to Western Sizzler,
evenings watching Hollywood’s latest mind-numbing blockbuster and six-dollar
extra-large frappalicilous drinks, which are one-tenth coffee, nine-tenths artificial
flavoring. Hints of the hit to take-home pay may already be evident in consumer
confidence numbers, which have dipped considerably after a steady climb through
the autumn.

The New Year also holds some potential upside surprises.
Valuations may continue to expand towards the historical average. One potential
catalyst for this would be jobs continuing to be created at a clip greater than
150 thousand monthly, a level achieved four of the past six months. By
increasing the size of the pie, a bump in employment would partially offset the
drag of the higher payroll tax. Improved
investor sentiment could also slow down…or reverse… flows away from equity funds
and into the bond market; this shift would add much needed volume, thus
validity, to the current equities rally.

Lastly, shares could benefit by a rebound in global demand,
namely from emerging markets, for American capital goods. Such a boost would reprise
the wave of manufacturing activity that was a source of strength during the
early stages of the recovery, but which has since tapered off.

Bonds

What Happened.

To the surprise of no one, the Fed extended its bond
purchase program known as Operation Twist
and when that petered out, announced a third round of quantitative easing
targeting not only Treasuries, but also mortgage bonds, which it had previously
ceased absorbing. Clearly fearing that even an eventual $3 trillion (I refuse
to type out twelve zeros) balance sheet would not be enough to catalyze growth,
the Fed also added language stating its intention to keep rates low until
joblessness hits 6.5% or when the cows come home, whichever arrives first.

As for the impact on
rates, if the yield on the two-year note were a patient’s heart rate, the next
of kin would be grabbing a shovel. It has been flat-lined at 0.25% ever since
the Fed began its extraordinary measures. (For
those who don’t follow the bond market closely, these shorter-dated notes are
the ones most tightly tethered to the Fed Funds Rate, which has been set….seemingly
in perpetuity…at 0%-0.25%). Long-term rates have been equally boring, with
the only move downward occurring mid-year when markets were spooked by the
combination of weaker emerging market growth and another abscess in the
Eurozone debt saga.

What Does it Mean?

Usually as an economy gets deeper into recovery, investors
shift their concerns from not enough growth to too much, which means inflation.
As sentiment changes, longer-dated bonds sell off. Three years into the
recovery this scenario has yet to occur as inflation remains tame and the Fed has
become the marginal buyer, supporting bond prices by absorbing large swaths of
the market. Unfortunately, this means tossing out the textbooks when it comes
to using bond yields as an effective gauge on how investors perceive future
growth prospects.

And Going Forward….

As seen in the chart, over the latter half of the year, the
spread between the 10-year and 30-Year has slowly trended wider. Look for this
expansion to continue, which in the real economy could translate into mortgages
going from absurdly low to simply extraordinarily low (for the few who
qualify). Also any sell-off in longer dated bonds will likely hit investors who
piled into fixed income over the past several years right in the teeth. Although the minutes of the most recent Fed
meeting hinted that some committee members voiced an interest in tamping down
on some of its easing initiatives by the end of 2013, one may risk asphyxia
should he hold is breathe awaiting that eventuality.

The Wrap Up

When the Fed announced its first wave of extraordinary
measures, there was much discussion on how such easing mechanisms would be
reversed. The expectation was that steps to absorb excess, temporary (hee hee),
Liquidity would be implemented within months. It has now been years and that aspect
of the conversation has faded from memory. Very little points to the Fed, or
other developed market central banks initiating any hawkish moves over the
coming year. But as it continues, even by the Fed’s own admission, QE has
diminishing returns. Eventually it may become white noise and another component
of The New Normal, marked by low growth
and weak inflationary pressure thanks to dreary aggregate demand and sticky
joblessness.

With regard to markets, should this scenario become
calcified, markets may finally return to moving mainly on the fundamentals
relevant to each asset class rather than any larger, policy-driven macro-overlay.
They would just do so with lower returns expectations. Should that occur, investors
may at least be able to generate excess returns by tactically adjusting
allocations as movements in major asset classes finally decouple from each
other. Solely for the sake of diversification, that would be a welcome step
indeed.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.